Sector primer: Layer 1 protocols

This article is part of our sector indices primers. Find out more about this series here and get the full report here.

Definition

The original blockchain protocols such as Bitcoin and Ethereum are referred to as the Layer 1 sector, as they are the basic infrastructure other types of tokens and decentralised applications are built on. They are the foundational layer for the entire crypto ecosystem.

The native tokens of Layer 1 platforms serve to secure their network. These crypto assets are also sometimes referred to as “cryptocurrencies” because they have inherent characteristics that make them a suitable medium of exchange and store of value – as long as they have an appropriate token supply model and the protocol has proven to be secure and robust.

Indeed, the original cryptocurrency, Bitcoin, was created to serve as an alternative monetary system while other use cases for blockchain networks developed later on.

History

The innovation of cryptocurrencies came after several attempts at creating digital payment systems, electronic currencies and digital systems for settling financial transactions eliminating the middlemen. Hashcash, Bit Gold and B-Money were some of the early attempts, which provided insights that informed the creation of the first successful cryptocurrency. These were complemented by advances in data science, cryptography and the invention of the distributed ledger technology, which provided the building blocks of the first cryptocurrency protocol.

Shortly after the launch of Bitcoin, various new projects launched that sought to improve on Bitcoin in some way. The early alternatives to Bitcoin were all modified versions of the Bitcoin protocol.

However, as developers discovered the potential of the technology, many attempted to build new types of decentralised blockchain protocols and proposed several innovative designs for cryptocurrencies. The most prominent of these was Ethereum, which became the second largest cryptocurrency after Bitcoin. The smart contract execution capability that Ethereum introduced has since played a crucial role in the further development of the crypto market. Proof-of-stake (PoS), the alternative consensus mechanism that has succeeded in providing a viable alternative to proof-of-work (PoW), was proposed in 2012, with Peercoin as its first implementation. Proof-of-stake protocols addressed the energy consumption problem of proof-of-work blockchains while also keeping the value created by the network inside the ecosystem rather than leaking it to miners. Some protocols, such as Fantom, implemented an alternative approach to blockchain: the directed acyclic graph (DAG), where transactions are directly connected to one another without the need for blocks.

The plentiful availability of capital for crypto projects during the initial coin offering (ICO) boom meant that many copycat protocols and forks were launched that did not create much value. However, next-generation innovative protocol designs, such as Tezos, were also created during this period.

As developing use cases highlighted the need for scalability, innovation focused on improving transaction speed and capacity with protocols such as Solana. The scalability issues of Ethereum also created the opportunity for newly launched chains with good market positioning, such as Binance Chain, to take market share from Ethereum.

As crypto adoption grew during the last bull market, innovation accelerated again to ensure that the foundational layer is suitable for the types and volume of transactions the growing use cases generate. This has brought further improvements in speed and security with the launch of protocols such as Avalanche, NEAR, Aptos and Sui, as well as the growth of sector- and application-specific chains.

Subsectors

The Layer 1 sector can be divided by the types of technology the protocols use, which can be blockchain, DAG or a combination. Blockchain protocols can be further divided by the type of consensus mechanism: proof-of-work (PoW) or proof-of-chain (PoS), or sometimes a combination of the two. Some protocols market themselves by claiming to have invented a new type of consensus mechanism; however, so far these have all been versions of PoS or PoW. Proof-of-authority is an exception; however, these protocols are centralised at the point where authority is granted, and therefore it is debatable whether they are truly part of the decentralised crypto ecosystem.

A further subsector is comprised of protocols that focus on providing high levels of privacy, protecting from government overreach. This subsector emerged as the crypto technology that was intended to be anonymous and censorship-resistant became increasingly traceable. The privacy subsector is somewhat controversial, and many investors shun it due to governments’ and regulators’ stance towards it. But some consider it the most important part of the crypto ecosystem and the purest implementation of the original vision of crypto.

Some divide the Layer 1 sector by the most prevalent use of that blockchain – whether the cryptocurrency is used primarily as money or store of value, or the protocol is primarily used as a smart contract platform. We find this definition fuzzy, as most major protocols can and do fulfil all those functions and their market share of the various use cases changes over time. Bitcoin, traditionally considered a store of value and a payment currency, has seen a renewed focus on developing smart contract capabilities and growing its transactions from use cases other than payments. Meanwhile, Ethereum has adjusted the supply mechanism, and the Ethereum community has been highlighting ether’s characteristics as a strong store of value and “ultrasound” money.

Users

Some cryptocurrencies (primarily Bitcoin) are used as an alternative to precious metals because they score highly on characteristics required for a good store-of-value asset, including scarcity, permanence, portability, authenticity, divisibility and secure storability.

Several cryptocurrencies are used also in payments. This is in part driven by demand from holders of crypto assets who want to avoid having to convert their crypto to a fiat currency before making a payment. The demand is also driven by macroeconomic developments, either on a global scale or in certain countries where the fiat system no longer serves the needs of the economy – for example, due to hyperinflation or currency restrictions.

The largest and fastest growing demand for Layer 1 protocols, however, comes from their use as a foundational blockchain for decentralised applications to build on, and for various token types, such as stablecoins, NFTs and tokenised assets, to be created. Private companies also use the crypto market for fundraising by launching their own tokens on Layer 1 blockchains.

Opportunities & Challenges

The Layer 1 sector benefits from the growth of the entire crypto ecosystem, as all use cases are built on top of this foundational infrastructure and generate transaction fees for Layer 1 protocols.

Some of the tokens in the sector also benefit from global macro instability, as they offer an alternative form of money. Although cryptocurrencies in their current form are not perfect money either, they offer an alternative and are a very interesting contribution to monetary system designs.

Regulation is highly relevant for the sector. The regulatory debate in the US on whether cryptocurrencies are commodities or securities specifically referenced some of the tokens in this sector while benefitting others (notably Bitcoin) that were overtly exempted from securities regulation.

Regulatory clarity can be a strong positive catalyst for institutional fund flows into crypto. On the other hand, if governments see cryptocurrencies as an unwelcome challenge to the fiat-based monetary system, this may have negative implications. Regulation around the energy use of cryptocurrencies could impact the proof-of-work subsector (such as Bitcoin), while the privacy subsector is regarded by most regulators as problematic.

A lot of technological progress has been made in recent years with regard to scalability and security, but innovation is still ongoing to make Layer 1 blockchains truly suitable for mass adoption and for the specific needs of various emerging use cases.

As new innovative protocols launch seeking to improve on the market leaders in the sector, their lack of longevity in itself poses a risk. Shared security solutions are a recent development to address this, in which smaller, younger networks outsource their security to established protocols such as Ethereum, Bitcoin, or Cosmos.

This also impacts the competitive landscape within the sector. The previous debate around whether the trajectory is towards a “winner takes all” outcome or a “multichain world” has become more refined. Market share in fulfilling some of the requirements for blockchains such as security may be highly concentrated among a small number of protocols in the long run, while the demand for features tailored to the needs of different users may invite significant competition and fragmentation. While network effects remain important, as the Web3 sector delivers interoperability solutions, the advantage of leading projects in this regard is somewhat reduced.

Concerns also centre around points of unintended centralisation for blockchain protocols. Although decentralised by design, certain single points of failure can still create risks, such as the reliance on internet service providers, centralised node hosting and concentration among staking service providers or among miners. Innovation is ongoing to develop solutions addressing these concerns.

Value drivers

Growing crypto adoption and acceptance are strong underlying drivers for the sector, and the emergence and growth of various use cases and applications of the technology underpins the medium- to long-term megatrend.

Institutional adoption impacts demand for crypto assets, while real-world collaborations bring potentially very large customer bases to blockchain projects. These developments may impact the sector directly or indirectly, as Layer 1 protocols benefit from all of the activity that takes place across the crypto ecosystem.

The macro environment (globally or in a given jurisdiction) impacts demand for cryptocurrencies as money and store of value.

Regulation will continue to impact the sector – this is both a risk and a potential enabler.
Innovation remains a driver as greater scalability, faster transaction speed and lower cost enable use cases that previously were not feasible.

Disclaimer

This document is purely for educational purposes and has been issued by Sygnum Group. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a marketing communication. It does not constitute an offer or a recommendation to subscribe, purchase, sell or hold any security or financial instrument. It contains the opinions of Sygnum Group, as at the date of issue. These opinions and the information contained herein do not take into account an individual‘s specific circumstances, objectives, or needs. No representation is made that any investment or strategy is suitable or appropriate to individual circumstances or that any investment or strategy constitutes personalized investment advice to any investor. Therefore, you must verify the above and all other information provided in the document or otherwise review it with your external advisors. Some investment products and services, including custody, may be subject to legal restrictions or may not be available worldwide on an unrestricted basis. The information and analysis contained herein are based on sources considered as reliable. Sygnum Group uses its best efforts to ensure the timeliness, accuracy, and comprehensiveness of the information contained in this document. Nevertheless, all information indicated herein may change without notice.